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Chapter 13: Problem 3

Does a decrease in the money supply cause a change in output, prices, or both?

Short Answer

Expert verified
A decrease in money supply could cause both a change in output and prices in the short run. However, in the long run, only prices are affected as output returns to its natural level assuming the economy is flexible.

Step by step solution

01

Understanding the relationship

When the money supply falls, people will have lesser money to spend on goods and services. Therefore, the decrease in money supply leads to a decrease in aggregate demand.
02

Effects on Output and Prices: Part 1

A decrease in aggregate demand shifts the AD curve to the left in the AD-AS model. In the short run, this results in a lower output as businesses will produce fewer goods and services due to lower demand.
03

Effects on Output and Prices: Part 2

Along with lower output, companies may lower prices to try to increase demand. Therefore, in the short run, both output and prices can decrease due to a decrease in the money supply.
04

Long-Term Effects

However, in the long run, output returns to its natural level because prices eventually adjust to the lower level of demand, assuming that the economy is flexible. This means that the effect on output is only temporary, while the effect on prices is more permanent.

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Most popular questions from this chapter

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